An attempt to explain in ordinary language the bizzare bazaar that is our financial system.

Tuesday, June 5, 2012

The Facebook IPO: An orgy of game theory in which everyone is screwed

So, I did my best to ignore the
Facebook IPO during the frenzy which led up to the actual issuance of
the shares. Sure I love Facebook, I'm on it all day. You're probably
reading this through a link I posted to it. The start of my career in
earnest was marked by Netscape, the first mind-blowing IPO of the
internet boom. I went on to make my first career trading equity
volatility in the telecom and media sectors during the first internet
mania and collapse. I went on in my career to build infrastructure
that supported the largest IPO in the history of the Middle East so I
know what the IPO process looks like from the inside. Still, I have
ignored the Facebook IPO and this is because, now that I know in
excruciating detail how the entire process works, it disgusts me.

So now the inevitable has happened. The
IPO process smashed into the hopes of the investors like a freight
train and clipped them for 18% of their investment in the first week
and 30% in the first two. It's hard to exaggerate just how big a
fiasco this is. Over $4 billion of investor funds are up in flames
and since this was meant to be “the peoples stock” with a massive
25% allocation to retail, mom and pop investors have been smoked to
the tune tune of over $1 billion. Ouch, that will leave a mark.
Indeed there have been a slew of articles talking about how the
Facebook IPO has cooled the IPO market for other companies in the
pipeline.

Now the recriminations begin. The
journalistic community and the tort bar have both been beating the
bushes to find the villains behind this who can be excoriated to
drive page views or vilified and then shaken down for cash. This is
entirely natural but I think it does a disservice to the public
because it seeks to explain the outcome in terms of personalities,
which granted are very interesting, but it allows the narrative to
ignore the complexities of the IPO process itself. I think this is a
disservice because in this case what has happened is not that some
villains seized control of the process, indeed while some dubious
decisions were made I'm quite certain that no laws were broken. No
no, the problem here is not that some villains manipulated the
process, the villain IS the process.

The important thing to keep in mind
that this story is not about what Facebook is actually worth in terms of its balance sheet or income statement. No human being could possibly
tell you that. Indeed, everyone with access to the US equity markets
voting with their dollars for the past two weeks can't come to an
agreement within $4 billion dollars on any given day. There have been
stories about how some analysts lowered their estimates but didn't
tell clients because of the quiet period and the implication is that
some people got advanced notice and trimmed their bids. Let me assure
you that anyone with privileged access to Wall Street research could
remember the '99-2000 era and knew full well that the pricing and
trading of Facebook was going to have nothing whatsoever to do with
what the Wall Street analysts though 2013 revenues were going to be.
The real value of Facebook has nothing to do with its revenues per
user, or its compound annual growth rate, or any other measurable
statistic. Everyone in the game recognizes that Facebook is a one
off, a business that no one fully understands other than to know that
it is huge with a ton of potential. Facebook is a dream of a company
and the price of a dream is easy to calculate: it is worth what
people are willing to pay for it. No more. No less.

Now I realize, dear reader, that this may
seem manifestly unhelpful but behind what seems a free market
tautology are the more disturbing questions about the Facebook
IPO and therein the black magic lies: Who came up with the the IPO
price and how did they do it?

The process by which an IPO is priced
is called a “book-building.” Bookbuilding is a slow motion,
mediated auction with several stages. The first is a filing with the
SEC announcing the intention to list, and giving the fundamental
details of the company and the offering as prescribed by law. Then
there is the road-show where the bankers and the management travel
around the country meeting with potential investors, answering their
questions and feeling them out for their interest in the deal. It's
kind of like dating where the company and its potential investors
meet each other, tell jokes, buy each other dinner, and decide
whether to take their relationship to the next level. Then begins the
formal book building. The bankers have made a back of the envelope
calculation of the company and come up with a range. In the case of
Facebook that range was $29-$34. Then they invite people to submit
orders to them.

There are several answers to the
question “who.” First there are the potential investors who at
the highest level can be broken down into retail and institutional
investors. Usually retail investors are not invited to submit bids,
their decision is generally a binary one: are they in or out at the
price whatever it may be. The people who determine the price are the
institutional investors. These in turn can be broken down into “hedge
funds” and “real money” who are mutual funds and the big
pension funds and insurance company funds. These institutional
investors decide how much they want to participate in the IPO and
then submit bids with a maximum price and for a specific amount of
shares. These bids are received by second half the the “who:” the
Equity Capital Markets (ECM) teams at the banks in the IPO syndicate
who then manage the how: the “book build.”

As I have said a book-build is a
mediated auction. By “mediated” I mean that the ECM teams, the
“auctioneers” if you will, have sole discretion in the
outcome of the auction both in terms of what the final price is and
in terms of which investors get how many shares. An unmediated auction is what you
might see at Sothebys recently when “The Scream” was auctioned
off. The bidders turn up at a set date and time, and then they bid
against one another and the highest bidder wins. In a book build the
ECM teams collect all the bids from all the market participants and
then they alone decide at their own discretion what the final price will be and which of the bidders
will get how many shares, indeed this is what the company that hired them to conduct the IPO is paying them for. This process is highly opaque but I will
try to illuminate it for you.

In business, as in life, always remember that people respond to incentives. If
you can discern the incentive system in which someone perceives
himself to operate you may as well have read his mind. So what are
the ECM guys trying to achieve? They have several objectives. First
of all they want the IPO to be a success and a successful IPO is one
in which both the company and the investors are happy. This is
important because if they shortchange the company they might have a
hard time attracting future IPOs and if the investors aren't happy
they might have a hard time selling future IPOs. That is, the ECM
guys want to stay in business.

Beneath that they have some conflicting
incentives with regard to the investors they select. In general they
want the stock to pop a little on the first day to make the investors
happy but not so much that the company feels as though it has left a
lot of money on the table. To achieve this the ECM guys try to manage
which investors get how many shares. They try to give large
allocations to “real money” investors who will be in for the long
term and small or zero allocations to “flippers” that is hedge
funds who are mostly investing in order to ride the one day pop and
then flip the shares. Within this there is also a certain quid pro
quo wherein large clients of the syndicate member who pay a lot of
fees and borrow a lot of funds and therefore pay a lot of interest
will receive favorable treatment come allocation time relative to
smaller clients and new clients had better be convincing that they
intend to expand the relationship with the bank into other areas. So
in sum, at the strategic level the ECM team needs to balance the
price between the company and the investors in order to stay in the
IPO game and on the allocation side they want to have the right mix
of investors to support the price and they want to reward their high
fee paying clients.

How about on the investor side?
Basically there are two kinds of investors the “real money” guys like
pension funds and insurance companies who are longer term in their
outlook and who generally rely on the constant contributions from
employees or policyholders to generate the funds they manage. Then there are the, mutual funds and hedge funds that have to compete with one
another for investor assets to manage. “Real money” accounts are generally
more patient investors and are mandated to match assets to future liabilities. Thus they tend to be more risk averse so they are more
sensitive to price in IPOs. If they think the price is rich, they'll
hold back and if they think the price is fair they'll participate to
a greater extent. They have a lot of influence over most IPOs because the ECM guys think they're unlikely to flip the shares but because they are so sensitive to price they are less influential in a deal like Facebook.

The incentive structure for the funds
that have to compete for investor assets are much more complex. First
of all remember how the managers are compensated. Generally mutual
fund managers are paid a percentage of assets under management and
hedge funds are paid a percentage of assets under management plus a
share of the profits of the fund. This means that for both of hedge
and mutual funds a primary driver for compensation is to have as many
assets under management as possible and, for the hedge fund managers,
if they can hit home runs while they have a lot of assets under
management they can become dynastically wealthy. Next remember how
they compete with one another for those assets, through a combination
of risk and return, they want the highest return for the lowest risk
possible and they need to produce better returns at lower risk than
their competitors.

Now think about what this means for the
incentive system in which the fund managers operate. IPOs, properly
priced, are almost a sure thing investment, so everyone has an
incentive to be involved. What's more some of the checks on the “real
money” funds don't operate on the “fast money” funds. Remember
that they are judged relative to their peers, so if everyone gets
into the IPO and it performs poorly then the fund managers are no
worse off, but if their competitors get in and they don't and the IPO
turns out to be a massive win they are behind from both a performance
perspective and a volatility perspective. So if it looks like there
might be a pretty good IPO coming down the pipe a lot of fund
managers will feel as if they must participate and therefore they are
likely to be pretty aggressive in trying to get into them and to get
as large an allocation as possible. It goes without saying that they are likely to be much more aggressive than the "real money" accounts in such a case.

So this brings us to the Facebook IPO
which has some unique features of its own. First of all is the nature
of the company. It is a unique and possibly the most widely known
company on the face of the Earth at the time of its listing. Given
its spectacular growth, its short operating history, and the fact
that is in a business which practically only existed as long as it
has mean that arriving at a valuation based on comparables or history
is virtually impossible. This means there are not a lot of solid
benchmarks for analysts and investors to anchor their valuations to
and that makes the mediated auction even more
influential in determining price. Also it relaxes the constriction on
the ECM team to get the price right. Since the IPO is so much
different from all other IPOs an error one way or the other won't
necessarily harm the future IPO business of the lead underwriter as
other firms might consider this particular IPO to be a one-off.

If the constraints on the ECM
team are relaxed a little on the valuation side of things they become
massively more intense on the allocation side. For something like
this anyone who is benchmarked against other technology funds
ABSOLUTELY MUST participate in the IPO. If it turns into a huge home
run and they are not in, their investors will wonder why. Did they
just not have enough influence with the syndicate to get an
allocation? Were they not smart enough to know that it would be a
huge hit? How could that be? It's Facebook for crying out loud! On
the other hand, since everyone has to be in, if the deal turns out to
be a dud then all their competitors are smoked as well so they're not
worse off on a relative basis. The thing is they have to get into the
deal and they have to get a meaningful allocation. And this is where
the game theory orgy takes over.

So let's say you want to get a large
allocation in a mediated auction. How do you do that? Well, you can try to make sure you are the highest bid. So when Morgan Stanley announces
the range is $29 to $34 you might want to be toward the top of that.
Of course this is Facebook so you can probably guess that there will
be plenty of people willing to pay $34 just to make sure that they're
in the game, so you might submit a bid above the range. Actually, the
syndicate will go you one better. They'll allow you to submit
something called a “no limit” bid that means you will match the
highest bid there is no matter what it is. Some nutcase is bidding $70 a share? You're with him. Of course you're assuming that whoever is the highest bid is less crazy than you, not always a safe assumption in this game and in any case you think the ECM guys won't price it too high lest it fall, also not a safe assumption. In essence, it is so important to you to get an allocation of shares that you're willing to abdicate your influence over the price to marginally increase the
chances that you get an allocation. Given how important it is for the
competitive position of the various funds I'm sure a great many did
precisely this. But it's not enough to get an allocation, you need to
get a meaningful allocation. Lets' say for example that you submit a
no limit bid for 100,000 shares and the IPO is oversubscribed many
times, you might come away with 7,500 shares. That's nothing! You may
as well not have been in the game. So if you want 100,000 shares, you
might submit an order to 750,000 shares. Then, when the bankers go
through their spreadsheets and decide who gets what now you might
just get a decent sized allocation. And you know you won't get the
full allocation because you know that the deal is sure as hell going
to be massively oversubscribed.

Well so this is what happened. There
the ECM guys are sitting in their conference room receiving bids all
day long for weeks in front of the IPO. They are literally deluged
with bids, a lot of them through the original price range. So many in
fact that they raise the price range to $34-$38. Then they are
deluged with “no limit bids.” So many that they can fill the
whole offer at $38. Then they're also swamped with the sheer size of
the share requests such that the IPO is “many many” times
oversubscribed. And that's not all, not only are you overwhelmed with
by the high price and the massive size you are absolutely swamped by
requests from every client service person in the firm to look after
their “very important clients.” It's hard to exaggerate the
pressure the ECM team is under in the final days of the book-build to
make everyone happy. And that's what the guys at Morgan Stanley tried
to do.

They raised the target range from up to
$34-$38 to make the company happy and in the end they priced it a the
top of that range at $38. They almost certainly had so many no limit
bids that they could have priced it even higher, I'm sure they
thought they were leaving something on the table for the investors.
They probably thought it would go to $45 or something on the first
day just when they saw the demand. Indeed, even after pushing up the
range they were still so overwhelmed with demand that they grew the
offering size by 25% this enabled them to give their clients larger
allocations and make all the whiney salespeople whine a little more
quietly. I'm sure that it seemed all was well.

Alas, it was not so. Now imagine the
position of our hypothetical hedge fund manager who, when the range
was $29-34 submits a “no limit” bid for 750,000 shares thinking
he'll get maybe 100,000. Well, now that they've grown the offer and,
if he's done a lot of whining, he's probably wound up with 250,000
shares at $38. Hey now! That might be a little too many shares at far too high a price, but let's
see how it trades on the open. Well, it trades up a little but there
are these problems at NASDAQ and it starts trading off, what is he
going to do? He's going to sell! And that is what has been happening,
the crazy people who wanted as much as they could get at any price
two weeks ago are getting shaken out and in their stampede for the
exits they are crushing the living daylights out of the stock.

And that in a very long nutshell is
what happened. There is no single villain or even group of villains.
The nature of the incentive system in which fund managers operate
compels them to bid with extreme aggression for access to an IPO of
this kind. The very aggression with which they bid relaxes the
incentives to constrain the valuation that operate on the ECM team
and pushes them in the direction of allocating more shares to the
institutional investors than they actually want which triggers a
massive wave of selling when the post IPO demand fails to match up
with the pre-IPO demand. Of course the Mom and Pop retail investors
who just wanted to own a piece of Facebook have no idea how this all
happens and most of them will probably hold onto their shares in the
hope that things will turn up someday.

Meanwhile, as of todays close they've
lost $1,450,000,000. Sorry guys, welcome to the big time.